Friday, September 23, 2011

Fiddling While Rome Burns?

Global stock markets plunged Thursday as investors worried that the U.S. economy, the world's largest, would not turn robust anytime soon and instead help drag the world economy into another recession.

U.S. stock markets plummeted about 4 percent in late-day trading, with the broad-based S&P index of 500 companies retreating to its lowest point of the year. The sharp stock sell-off began in Asian markets, quickly spreading to bigger losses on key European exchanges in London, Paris and Frankfurt, where investors also feared a possible Greek debt default.

The closely watched Dow Jones Industrial Average of 30 key stocks on Wall Street lost more than half of the amount it has dropped for all of 2011 in just five and a half hours of trading Thursday .

Prices for commodities also dropped, with oil sliding nearly 5 percent, dipping below $80 a barrel for the first time in a month on worries there would be less demand with a global economic downturn. Even the price of gold, often viewed as a safe haven for investors, skidded, but U.S. bonds were still viewed favorably as a protected investment.

The managing director of the International Monetary Fund, Christine Lagarde, said the world's biggest economies need to strengthen their collective efforts to restore stability to world financial markets. She said that global leaders have not exhibited the same sense of momentum and spirit they did to resolve economic difficulties as they did at the height of the recent recession.

Lagarde said the risk against global economic growth has “increased markedly,” but added that so far world financial markets have ignored “bold” corrective efforts taken by European countries to cut their government debt.

The global stock sell-off began after the U.S. central bank, the Federal Reserve, said Wednesday it sees “significant downside risks” in the outlook for the American economy.

The Fed said a complete economic recovery is years away, and announced a plan to sell $400 billion of short-term bonds and buy long-term Treasury notes in an effort to keep interest rates low and boost economic growth. The central bank's action had been expected.

Analysts said that the gloomy forecast for the U.S. economy, coupled with worries that Greece may eventually default on its international bailout loans, could lead to a new global downturn or at best continued sluggish growth.

"The rapidly burning fuse is in the European banking system, particularly in France, and Europe is getting very close to yet another tipping point," PIMCO's Mohamed El-Erian writes in The Financial Times, which separately reports executives of BNP Paribas plan to tour the Middle East in an effort to raise capital this week.

Amid acute concern over French banks, the CAC 40 plummeted more-than 5% intraday in Paris Thursday before stabilizing a bit. Major bourses across Europe were down more-than 4.5% in recent trading and the price of credit default swaps on European corporate and sovereign debts were surging; the price of default insurance on German and French sovereign debt hit record levels, Bloomberg reports.

In recent trading, the Dow was down 283 points, or 2.5%, while commodities such as gold and oil were falling sharply as the dollar rallied vs. the euro. (Update: As of 12 p.m. ET, the Dow was down nearly 400 points, or 3.6%, at 10,728 while the S&P was off 3.3%.)

In addition to fears of a European banking crisis, global markets were hammered by weaker than expected manufacturing data in Europe — which showed contraction for the first time in 26 months — and China, as well as a rise in U.S. jobless claims.

As Henry and I discuss in the accompanying video, the surprising thing is that anyone is surprised this is happening. The Greek debt crisis has been long in the making and European policymakers have had more-than ample opportunity to address the resulting problems among EU banks.

There are reasonable solutions to address the crisis, including the so-called "Swedish Solution" where banks are forced to take major write-downs before getting a capital injection. Alternative, Europe could adopt a TARP-style program to provide a capital cushion for banks ahead of an inevitable Greek default. Neither program is perfect but either beats doing nothing, which appears to be the plan in Europe right now.

Literally and figuratively, EU policymakers are fiddling while Rome burns.

Plus, Bernanke would be pilloried if the Fed had launched a $1 trillion QE3 program or some other outsized plan this week. From where I'm sitting, Bernanke gets an "A" for effort and looks good compared with our dysfunctional Congress and, especially, Europe's disastrous policymakers.

The epicenter of this crisis remains Europe, but I have to tell you, watching the price action yesterday, I remain convinced that naked short sellers, high frequency trading (HFT) scammers, and large hedge funds and bank prop desks are having a field day, making a killing in this wolf market (still waiting for the SEC to reinstate the uptick rule!!!).

And why not? With the Fed pretty much out of the way, they're watching inept European politicians incapable of coming up with a robust solution to their debt crisis and shorting every risk asset in the world, including stocks, commodities, commodity currencies, corporate bonds, and even gold. Only US bonds rallied, pushing yields on Treasury 30-year bonds down the most over two days since the depths of the financial crisis almost three years ago.

Let me reiterate something: If Greece defaults, it will be catastrophic for Greece, Europe, and the global economy. The bond market, which is much bigger than the stock market, is worried about global deflation. It's sending a clear signal to global policymakers but this warning is falling on deaf ears. The global economy alarm bells are ringing but politicians all around the world are incapable of coming up with a coordinated response to put an end to these endless speculative attacks which are feeding off their incompetence and wreaking havoc on global markets.

So is it time to get out of the market or short it waiting for the "Mother of All Crashes"? NO! I think short sellers will get whacked hard because they're getting extremely greedy, but I warn global policymakers, if you do not come up with a timely coordinated response -- THE MOTHER-OF-ALL RESPONSES -- which includes reinstating the uptick rule, regulating rating agencies, hedge funds and all OTC derivatives, prosecuting naked short sellers and HFT scammers, recapitalizing European banks, restructuring debt from some countries, creating a European Treasury which emits euro bonds, then global markets will implode and another great Depression will ensue. I can't be clearer than this. It's time for global leaders to step up to the plate and stop fiddling while Rome burns.

I leave you with an interview with Nobel-prize winning economist and economic advisor to prime minister Papandreou (not that he's listening to him!), Joseph Stiglitz, which was broadcasted Thursday on Greece's SKAI TV. It was in English but there is a Greek voice-over. Mr. Stiglitz warns us that austerity measures are failing in Greece. He thinks the focus should be on growth, not austerity, and that a default and exit are going to end up costing Europe a lot more than restructuring the debt and keeping Greece in the eurozone. Click here to watch the interview.

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I am an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. I have researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). I've also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system. You can follow my blog posts on your Bloomberg terminal and track me on Twitter (@PensionPulse) where I post many links to pension and investment articles as well as my market thoughts and other articles of interest.

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